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Nobel Prize in Economics Sciences – 2012
Stable Allocations and the Practice of Market Design
This year’s Nobel Prize was jointly awarded to Alvin E. Roth – Professor of Economics and Business Administration (on leave) at Harvard Business School – and Lloyd S. Shapley – Professor Emeritus of Mathematics and Economics at University of California, Los Angeles (UCLA) for the theory of “stable allocations and the practice of market design”.
There are many situations where the traditional laws of demand and supply doesn’t apply and price systems based on capitalism may raise legal or ethical issues, for instance, allocation of public-school places to children, or the allocation of human organs to patients who need transplants.
This Nobel Prize winning work is a theoretical framework for analysing resource allocation, as well as empirical studies and actual redesign of real-world institutions such as labour-market clearinghouses and school ad-missions procedures
A model with 2 sets of agents is considered that must be paired with each other, for e.g. labours and employers. If a particular worker is hired by employer A, but this worker would have preferred employer B, who would also have liked to hire this worker (but did not), then there are unexploited gains from trade. If employer B had hired this worker, both of them would have been better off. A pairing is stable if no such unexploited gains from the trade exist. In an ideal market, where workers and employers have unrestricted time and ability to make deals, the outcome would always be stable.
In this framework, a Deferred-acceptance procedure is used which always leads to a stable outcome. The procedure specifies how agents on one side of the market (e.g., the employers) make offers to those on the other side, who accept or reject these offers according to certain rules.
In a study published in 1984, Roth found that the U.S. market for new doctors had historically suffered from a series of market failures, but a centralized clearinghouse had improved the situation by implementing a procedure essentially equivalent to the ‘deferred-acceptance’ procedure. This procedure has been proved useful in designing institutions that help markets function better, often by implementing a version or extension of it. This has led to the emergence of a new and vigorous branch of economics known as market design.
Two properties of key importance for market design are stability, which encourages groups to voluntarily participate in the market, and incentive compatibility, which discourages strategic manipulation of the market. The notion of stability is derived from cooperative game theory, while incentive compatibility comes from the theory of mechanism design, a branch of non-cooperative game theory which was the subject of the 2007 Nobel Prize to Leonid Hurwicz, Eric Maskin and Roger Myerson.
Economists are quibblers at heart each convinced that their opinion prevails. Right from the beginnings of economics at a science, economists had differed in the way they look at things. This is primarily because economic models have certain assumptions inherent in them, which can differ from economist to economist. Thus we have Krugman engaging Thurow, Keynesians clamour about how they were right all along, Levitt plunges even more into the obscure and Greg Mankiw tries to irritate everyone. In EconomistSpeak, we try to bring to you last word of economists themselves, who wear their hearts on their sleeves i.e. their blogs. Excerpts, debates, opinions and outright slugging matches - all this and more!
This week Mankiw is back to his favourite past time, i.e. bugging Krugman. In a somewhat pompously titled post "Krugman Re-estimates the Mankiw rule", Mankiw points out that a recent scatter plot from Krugman's article in the New York Times on "The Taylor Rule and the Bond Bubble" is inspired by a version of the Taylor Rule that he proposed. The scatter plot indicates the relationship between inflation rate minus unemployment rate and the federal funds rate. Krugman through his article tries to project a federal funds rate that would be viable given the projected rates of inflation and unemployment over the next 10 years. As for the mysterious Taylor Rule - it is a rule of monetary policy that determines how much the Federal Reserve should change its interests given the deviation between actual inflation rates and target inflation rates.
The x axis on this graph indicates the inflation rate while the y axis shows the federal funds rate. The graph uses data from 1988 to 2008 and shows that over 20 years, the federal funds rate shows an increasing trend with increasing levels of inflation minus unemployment. As Mankiw puts it in his early blog entry on this subject:
"Federal funds rate = 8.5 + 1.4 (Core inflation - Unemployment).
Here "core inflation" is the CPI inflation rate over the previous 12 months excluding food and energy, and "unemployment" is the seasonally-adjusted unemployment rate. The parameters in this formula were chosen to offer the best fit for data from the 1990s." The rationale for this formula comes from another paper which Mankiw published where he says:
"Imagine that some event--an accidental overheating of the economy, an adverse supply shock, or a sudden scare about impending inflation--starts to drive up expectations of inflation. If the central bank is targeting the nominal interest rate, the rise in expected inflation means an automatic fall in the real interest rate. The fall in the real interest rate stimulates the aggregate demand for goods and services, which in turn puts upward pressure on prices. The rise in prices confirms and reinforces the inflationary expectations that began the process.
Thus, expected inflation begets actual inflation, which in turn begets even higher expected inflation. The central bank, committed to its interest-rate target, ends up increasing the money supply at an ever more rapid rate."
Thus we can see that the interactions between actual inflation rate and the expected rise in inflation often drive up the inflation rate itself.
Krugman, rather caustically, says: "My sense is that a lot of people just can't bring themselves to face the reality that we're likely to be in a zero-interest world for a long time. They just keep assuming that the Fed is going to raise rates soon, even though there is absolutely nothing about the macro situation that would justify such a rate increase."
If you all will recall, the rise in interest rates is supposed to be one of the first signs that an economy is out of recession. A low interest rates signifies that the government is trying to pump more money into the economy to increase spending. Raising the interest rates indicates that the economy is out of the slump and that the government can afford to reduce the money supply. Krugman's ominous prediction is that interest rates will remain near zero level for a fairly long time. Mankiw however makes no such predictions - he merely seems thrilled that his model has been used. As he says:
"I think Paul and I agree that this (read ‘my') equation provides a reasonable first approximation to what the Fed will and should do in response to macroeconomic conditions."
Mankiw for the win!
Greg Mankiw's Blog
And finally for your listening pleasure, a rapversion of 10 basic principles of economics: